Viva Las Vegas!
We received a record amount of responses to our last commentary, An Idle Thought. We were thrilled it struck a chord with so many people. We were discussing possible reasons why so many of you responded. We quickly ruled out the possibility that our readers find Malcolm Gladwell more thought-provoking than us. I guess we will never know the answer to this mystery. Most of your responses were quite positive, although the content of this commentary focuses on a concern one of our readers had. Specifically, one of our west coast readers believes we are too positively oriented. Admittedly, from a non-investment perspective, we prefer viewing the world as if the glass is half full. We find it a more enjoyable way to live our lives. From an investment perspective however, we work hard to make sure our investment process has no bias. Numbers guide our decision-making process. We are all in need of a good vacation these days, so let’s take a virtual trip to Las Vegas. Advertisements for Las Vegas emphasize a vacation lifestyle that doesn’t exactly highlight the importance of making logical decisions. Yet the gaming industry is a great example of how logical decision making wins out over emotional decision making. (We wrote their tourism bureau and suggested they rebrand themselves to reflect this, we haven’t heard back.) Allow us to state the obvious; big beautiful casinos that offer free drinks wouldn’t exist if gamblers won more money than they lost. Casinos, and successful investors, understand the importance of playing the odds. The roulette wheel is the simplest example of how “the house” uses odds (logic) to systematically take money from gamblers. There are 38 slots on a roulette wheel that the roulette ball can fall into as it spins around. 36 of those slots are red or black (18 red and 18 black), 2 are green.
If you bet that the ball will land on red and it does, you double the amount of your bet. If it doesn’t, you lose your entire bet. The same is true with black. The payoff (doubling your money) reflects the odds of winning as 50%, effectively a coin toss. Your actual odds of winning are only 47% since the ball can also land in one of the two green slots. The casino knows even though some gamblers on a lucky night will win more money than they lose, on average, gamblers will lose more money than they win. Perhaps more importantly, gamblers that do win may incorrectly believe they are on “hot streak” and continue betting more until they lose back the money they won. The more spins of the roulette wheel, the more this becomes a mathematical certainty. The two extra green slots on the wheel tilt the odds so that roulette players will lose 53% of the time and only win 47% of the time. Here are some interesting odds that investors should be aware of. The S&P 500 stock market returns date back to 1926, almost 100 years. During this period, we have experienced the Great Depression, WWI, WWII, 9/11, and many other difficult periods, including this pandemic. Despite these incredible challenges, a stock market investor’s odds of winning over a 1-year period are 74%. Over a 5-year period, those odds improve to 86%.
Here’s another interesting probability that is counterintuitive, but investors need to be aware of. A portfolio that holds only bonds has a higher probability of losing money over shorter-term periods than a portfolio that holds both stocks and bonds. More specifically, an investor minimizes their probability of losing money over shorter-term periods by holding a 30% equity position and a 70% bond position. This is due to the inverse correlation between stocks and bonds. When bonds lose value, oftentimes stocks gain enough value to offset those losses. For this reason, our Conservative Strategy's strategic allocation is 30% stocks and 70% bonds.
Our process has and will continue to emphasize the importance of identifying the investor’s time horizon and designing a longer-term strategic allocation that maximizes the odds of success for that investor and their investment horizon. We tactically tilt the portfolios in the short-term to reflect the over and undervaluation of asset classes. This further adds value. What we do not and will not ever do is recommend a dramatic shift from your strategic portfolio, such as moving an entire portfolio to cash. This jeopardizes the longer-term integrity of the strategic allocation. As investment managers, we need to understand and accept that longer-term market forecasts are far more dependable than shorter-term forecasts. This pandemic is a great example of the dangers of letting emotion overrule logic in the short-term. Stocks fell 34% in a little over a one-month period when news of the pandemic hit. Amazingly, stocks are now higher by 7% over the last one-year period.
We continue to work hard at eliminating all bias from our investment process, whether positive or negative. Our decision to always maintain equity exposure is not because of positive bias, it is because of the odds. As investment advisors, one of the most important roles we play is to keep investors from being too aggressive during the good times and too defensive during the difficult periods. That’s the key to achieving longer-term investment success. One last thought - we miss all of you. Whether it's getting together for a drink and a bite at the Salt Box or simply sitting down at your kitchen table to review your portfolio. As we mentioned above, we allow ourselves to be positively biased on non-investment issues. Here's our observation; only two months ago it was dark and cold outside, we were locked down in our homes, and headlines warned of an extremely dire future. As we write this commentary it is sunny and warm out, restrictions are starting to ease, and worse case scenarios are no longer being discussed. Let's all continue to be vigilant and hopefully, we can see each other again soon. Positively yours, The GreenPort Team